by Michael Hampden-Turner, Director, Fixed Income and Multi-Asset Applied Research
While there are many factors driving the macro backdrop, inflation must be quite high on the ‘most important’ list. High inflation means that central banks will hike rates to help cool it down even at the risk of a ‘hard landing’. Hard landings are not good for equity or credit markets. If inflation is largely driven by higher commodity prices, then the question is: will raising rates to fight it even help?
Let begin by breaking inflation down into its constituents taking the US CPI index over a year.
Energy has seen by far the biggest growth, but only makes up 8.3% of the basket. Although energy is also an input to many other categories in the basket. The starting point one year ago, April 2021, was in the middle of the pandemic which is a low base to start from.
The next biggest growth category is Food, influenced by disruption to global supply chains, energy (again) and higher agricultural commodity prices.
It is instructional to rank the lower-level categories in order of growth size. Chart 2 contains all the subcategories which came in higher than the ‘all items weighted average’ of 8.3%.
Chart 2. US CPI-U by narrow expenditure category, April 21- April 22, % increase NSA
Yes, every category above the weighted average is either energy, commodity, Covid or supply chain related.
This leaves central bankers with a considerable dilemma.
- Inflation in G7 countries is at a high not seen since the early 80s and action is needed
- This is largely driven by the Ukraine war, and a de-escalation seems distant
- It is also partly still an overhang from Covid supply chain disruption (especially China)
- Without some QE unwind there will be limited ammunition for future crises
- Squeezing the economy with higher rates may have a fairly limited effect on non-discretionary expenditure mainly subject to global commodity prices
- Expectations for action are running high and becoming a political issue
It is common at this point in the economic cycle for central bankers to come under pressure for their handling of the economy. To a certain extent this is natural: nobody likes to get squeezed or see investment values fall. However, left and right-libertarians typically use the opportunity to virtue signal with stinging attacks and calls to defund/cancel/take-control from central banks. Government PR teams realise they can divert vox populi anger away from leaders. With the benefit of hindsight, pundits will claim central banks should have squeezed earlier / harder / less hard depending on their leaning.
While central bankers are independent, this pressure and a need to tackle inflation expectations, may mean that they opt for steady rate increases up until the point that greater clarity on commodity prices is possible. While being tolerant of inflation was a likely response to Covid, flipping the other way seems more likely even if it is understood to be less effective. Overcompensating seems more likely, and a soft landing seems increasingly hard to engineer.
What does this mean for markets?
It would seem like a good time for inflation products but the scale of the fixed income correction has left investors out of pocket as our colleagues in research have pointed out. Essentially, inflation linked bonds remain a high duration fixed income product despite benefiting from the inflation uplift.
The correction in the Russell 1000 has been a savage 30% since the peak at the end of last year. But looking at Chart 3 this looks mild relative to the last ten years of gains and mild relative to levels pre-Covid. Our colleagues in equities point out that in sector terms the correction is mainly mega-cap tech, retail and discretionary; cyclical sectors that have been rerating upward unsustainably for years. The Global Financial crisis in 2008 saw a correction of over 50% peak to trough. In this context, a further squeeze by year-end seems possible.
Chart 3. Russell 1000 index has declined 30% but remains above pre-Covid levels
Fixed income looks like it might be at more of a crossroads than equities. Consider the benchmark 10-year US treasury currently near 3% in yield.
Chart 4. 10-year US Treasury yield, %
The 10-year US treasury is near a decade yield high having twice reached 3% before during that time. Quite a lot of bad news is already priced. The Fed are guiding to 2.5% policy rates by next year and markets are pricing something similar. From here, evidence of a stronger economy and higher inflation will likely push the 10-year yield towards 3.5% as the market prices for higher policy rates. Evidence that inflation and the economy are cooling, and that the Fed Funds will not need to get to 2.5%, should stabilise rates here. But there are wild cards: A broader war, worsening Covid in Asia, and QE unwind to name a few. As with equities, the risk of higher yields before year-end seems likely.
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